What Makes Your House a Unique Investment?

House CollateralOne of the biggest misconceptions many homeowners have is that their house is the best investment they’ve ever made.

Let’s take a closer look. If you purchased a $250,000 house in 1990 and put 100% down (paid $250,000 cash), and sold it in June 2003 for $600,000, you would have realized a $350,000 profit, which is a gain of 140%. That is an annual compounded return of 6.453%. During the same period, the Dow Jones Industrial Average grew from 2590 to 9188, a gain of 255%. That is an annual compounded return of 9.466%. If you had invested in the right stock(s) during that time you may very well have experienced that 255% gain. If, however, when you purchased the $250,000 house in 1990, you only put $50,000 (20% down), that $50,000 would have produced the same $350,000 profit that paying cash produced. That is a total return of 600% (an annual compounded return of 14.912%), which far outpaced the measly 255% earned by the stock market and the 140% that paying cash would have earned.

But the truth of the matter is that neither the $250,000 paid in cash, nor the $50,000 down payment, had anything to do with the returns. In fact, the house would have increased in value by the same amount if you had put no down payment. Except in that situation, the return would have been infinite because $0 became $350,000 and there is no way to calculate a rate of return because there was no investment on your part.

The reality here is that financing your house was the best investment decision that you ever made. Financing your house allowed you to use a concept known as leverage. So, what is leverage? If you want to purchase $250,000 of Microsoft stock how much money do you need to purchase it? $250,000 right? If you want to purchase a $250,000 house how much money do you need? $50,000? $25,000? $12,500? $8,750? How about $0? You can get a conventional loan with a 20% down payment ($50,000), a 10% down payment ($25,000), or a 5% down payment ($12,500). You can get an FHA loan with a 3.5% down payment ($8,750). Or you can get a VA loan, provided you are a veteran or an active duty service person, with 0% ($0) down payment.

Financial Leverage 2Leverage, in the financial world, is the ability to control a large asset with a small asset. With $8,750 you can control $8,750 of Microsoft stock or a $250,000 house. Which would you prefer to own and control? If the stock were to increase in value by 10% your gain would be $875.00. If the house were to increase in value by 10% your gain would be $25,000. Leverage is like a time machine for your money. It can decrease the amount of time it can take for your money to grow (or shrink) in value.

However, leverage can work against you as well. If the stock were to drop by 10% you would “lose” $875.00. If the house were to drop by 10% you would “lose” $25,000. I put the word lose in quotation marks because you don’t actually lose anything until you sell, and you are much more likely to sell a stock that loses 10% than to sell your house if it loses 10%. Selling a house typically takes much longer than selling a stock and it’s far more disruptive.

If you buy a house with cash, you employ no leverage. If you buy a house using a mortgage, you are using financial leverage that amplifies the return on the investment, and there are few investments that allow you to utilize leverage, which makes a house a unique investment.

In the US economy, more private wealth has been created through real estate than through any other single investment. Americans’ house wealth wasn’t created through the investment of vast sums of money. Rather, it came from relatively small sums that worked over time with the powerful impact of both compound interest and leverage.

The answer to the question, “Is the house a good investment?” is it depends. It depends on who you ask and what criteria that person is basing their decision on. All things considered, I believe a house IS a good investment. What do you believe and why?

If you’re interested in learning more about the house as an investment and how owning a house can help you grow your wealth contact us to schedule a time to talk about your specific circumstances.

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